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On August 8, 2008, PPL Energyplus filed what appears to be the first legal action calling into question the enforceability of an emissions allowance contract in light of the United States Court of Appeals for the District of Columbia Circuit’s (the “D.C. Circuit “) decision vacating the Clear Air Interstate Regulations (“CAIR”) in North Carolina v. EPA (No. 05-1244). PPL is asking the U.S. District Court for the Southern District of New York to find that the D.C. Circuit’s decision to vacate CAIR makes it impossible to perform under an agreement that required PPL to purchase annual NOx allowances (Civ. Action No. 08-cv-7105, Judge Gardephe).

Under the option contract at issue, PPL had an obligation to purchase annual NOx allowances from its counterparty. PPL argues that, as a result of the D.C. Circuit’s July 11, 2008 decision vacating CAIR, that obligation no longer exists. According to PPL, the vacatur means there is no requirement that power generators surrender allowances for NOx emitted in a year, no NOx allowances issued pursuant to CAIR, and no provisions for transferring NOx allowances between market participants. In light of the above, PPL is asking the District Court to declare that the vacatur of CAIR makes it impossible for PPL’s counterparty to transfer NOx annual allowances to PPL as contemplated by the option contract and, consequently, that PPL is excused from performing under the contract and has a right to terminate the option contact in question.

The complaint comes as a surprise for several reasons:

The NOx allowances are still trading in the market, albeit at lower prices. In addition, the EPA is still processing registry requests to transfer allowances via the agency’s Allowance Tracking System. This suggests that the market and EPA do not necessarily see the immediate impact of the D.C. Circuit’s CAIR decision in the same way as PPL.

The Court vacated CAIR based on the overall conclusion that the EPA failed to follow Congress’ mandate in the Clean Air Act (“CAA”), and the flaws were so numerous as to prevent the Court from remanding only portions of CAIR back to the EPA for further revision. However, until the appellate process runs its course, it is not possible to determine with certainty the final fate of CAIR. More specifically, the D.C. Circuit has not issued its mandate telling the EPA that CAIR is dead and there have been no further procedural steps that take CAIR off the books. This procedural limbo means that CAIR technically still exists until the D.C. Circuit’s action becomes final – something that normally occurs after the appeals process has run its course and the court issues its mandate to the EPA. Requests for rehearing are due August 25, 2008, although the United States has asked for a 30-day extension to seek rehearing, thereby pushing the due date out until September 24, 2008. If parties seek rehearing, then the mandate telling the EPA to vacate the rule is stayed. Thus, notwithstanding the court’s clear vacatur, it appears that the CAIR obligations and allowances remain in effect – at least for now.

PPL claims that the contract allows for termination if the CAIR trading program was eliminated due to government action. Paragraph 9 of the trade confirmation says that either party may terminate upon written notice to the other if the rules or regulations establishing the annual NOx program eliminate the annual allowances. However, the fact that PPL is asking the court to rule on this provision suggests that it is not so clear whether there is a legitimate basis for terminating the contract or excusing performance.

Ramifications

If the District Court grants PPL’s requested relief, it is likely that other parties to allowance contracts may attempt to avoid having to take delivery of allowances under their contracts notwithstanding the lack of finality associated with the CAIR decision and any appeals. However, the District Court also might rely on Paragraph 9 of the confirmation in question to find, as PPL argues, that the parties agreed they could terminate the contract due to government action. In that event, the court's decision might bolster attempts to avoid performance, but only for contracts that expressly and clearly contemplate such an outcome as a result of government action.

Background on CAIR

CAIR’s purpose was to eliminate or mitigate the effect of upwind sources on downwind states’ ability to achieve or maintain air quality standards for particulate matter and ozone. The rules required 28 upwind states and the District of Columbia to include control measures to reduce SO2 and NOx which are precursors to particulate matter and ozone pollution. To facilitate the emissions reductions called for by CAIR, EPA established an optional regional trading program pursuant to which the upwind states could, in addition to reducing emissions, acquire allowances to address emission reduction requirements.

The rule was challenged on several grounds by each of States, electric utility companies, and other parties. At issue were, among other things, (i) the validity of EPA’s regional trading program; (ii) the extent to which EPA adequately considered, not only whether upwind states significantly contributed to downwind states pollution, but also whether upwind states interfered with downwind states’ ability to maintain current compliance with air quality standards; (iii) SO2 and NOx budgets; and (iv) forfeiture of Title IV SO2 allowances.

On each material issue, the court held that EPA exceeded its statutory authority in establishing the relevant provisions of CAIR. In essence, the Court held that where the CAA directly addressed an issue, EPA cannot contravene Congress’ express written intent and where EPA has contravened the CAA’s language, it is not entitled to deference.

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